There is still no end in sight to the global financial crisis that has been raging for over a year. The potential for crisis will continue to preoccupy financial markets and investors until well into 2009 and hover over the stock markets like the sword of Damocles. The capitalist world system is being shaken by the most severe turbulence in the financial system since the world economic crisis of 1929.
Stock markets have lost around 40 % of their value1 since their peak in October 2007, while fire sales have forced down the price level of many of the securities not traded in the markets. Ex-US Federal Reserve chief Alan Greenspan is right to call it the crisis of the century. Since the spring of 2007 a process of devaluation has been sweeping across the balance-sheets of financial institutions and still has the potential to gather momentum. Devaluation means, starting with a rapidly growing number of mortgage loans, that homeowners can no longer afford to service through interest and principal payments, that almost all types of securities are downgraded from their nominal prices to current market listings. Shares too are sucked into the downward spiral. All previous records have already been broken: The value adjustments to September of financial institutions alone are estimated at around 600 billion dollars. Corrections in stocks and shares amount to over 20 trillion dollars worldwide compared to the highest level. In the USA, around 900 billion dollars of public money has so far been invested in an attempt to ease the financial crisis. The bank bailout plan for “distressed loans” and troubled stocks and shares was passed by the US Congress in the teeth of strong opposition – not just on account of the gigantic sum of 700 billion dollars, but also because of the terms.
The bailout package has been improved in several areas. It now includes more protection for savings and deposits, as well as additional measures aimed at stemming the wave of forced house sales. Politically, the modified bank bailout plan can be summed up thus: the initially dominant focus on “Wall Street” has been realigned through a series of components in favour of the average “Main Street”.
The mortgage institutions Freddie Mac and Fannie Mae, which up until mid-2008 were only half state-owned, have been fully nationalised. The risks involved in this huge nationalisation operation have been largely underestimated. The key to the current crisis lies in a massive real-estate bubble in the United States, where there are loan agreements for around 12 trillion US dollars. Because the prices of houses are now in chronic freefall, more and more people are defaulting on their mortgage loans, i.e. they are no longer able to service them through interest and principal payments. Almost 50 % – i.e. mortgage loans to a value of 5.4 trillion US dollars – are held through Fannie Mae and Freddie Mac. Despite their semi-nationalised status, these institutions quickly collapsed, because they could no longer sustain such a level of debt with equity of only 40 billion dollars and increasing depreciation. Even the planned recapitalisation of a further 200 billion dollars by the US government would not compensate for the expected losses. Overall, the average fall in real-estate prices is expected to be between 20 and 30 percent. The now nationalised mortgage institutions will have to adjust to a volume of losses amounting to more than one trillion dollars. It is therefore logical that most experts should remain unimpressed by the current rescue position for Fannie Mae and Freddie Mac. The dubious nature of the bailout package is also evident in another respect: Congress has approved 300 billion US dollars for the mortgage insurance broker Federal Housing Administration. As part of a government programme, distressed loans will be refinanced and backed by state guarantees. Containing the real-estate crisis will demand far more public money than this.
By coming to the rescue of the big banks and nationalising a large percentage of mortgage loans, the Bush administration hoped to have shored up the financial system. But that was before the collapse of the American International Group (AIG) smashed all previous records.
During the boom of the international financial markets, the insurance industry added a new business category to its repertoire, so-called “financial products”. These allowed financial institutions to insure themselves against credit risks and failures. At the height of the stock market bubble, AIG had taken on insurance for 441 billion US dollars worth of securities. Almost 58 billion dollars of these relate to the segment of subprime mortgage loans. The wave of insolvency and value adjustments dragged AIG inexorably down into the vortex of the crisis. At the beginning of October, the US Federal Reserve loan to AIG amounted to 122.8 billion US dollars. The group, which at the height of the asset bubble had a market value of over 190 billion US dollars, was left trading at just 7.4 billion dollars at the time it was rescued by the FED. The loan from the Federal Reserve is covered by securities, and the US government has taken an 80 % equity stake in the ailing concern.
The jury is still out on whether the measures taken so far will work. The US government has indicated that it is ready to do whatever it takes. It will use all the means at its disposal to stabilise the financial system. And that includes direct nationalisation of financial institutions. As in the United Kingdom, the US government is ready take over central banks and to get credit flowing again by injecting new capital into the frozen system.
The chain therefore looks like this: it starts with massively inflated real-estate prices – followed by mortgage loans that are not backed by adequate deposits. The collapse in housing prices drags mortgage loans, the banks and other financial institutions into the downward spiral. This leads to the drying up of credit transactions between the banks. Intervention from the central banks only escalates the loss of confidence. The price of some stocks is determined by fire sales and all types of securities suffer a major devaluation compared to their peak values. Insurance policies on loans are also drawn into the crisis. At another level, the lifeinsurance brokers have many of their reserves invested in stocks, bonds and securities. In Japan, one large life insurance company has filed for bankruptcy.
Germany has not been exempt from the growing demands for a widening of the regulation and safety net. Owing to the specific consequences of reunification with the former GDR, Germany has had to assimilate a huge amount of real-estate stock, which has depressed prices over the last few years. For this reason Germany did not participate in the international boom in property prices (as Japan also did not). Moreover, Germany has a much stricter code of practice as far as property loans, etc. are concerned, and on the whole banks have a higher equity ratio. Not least, the extensive network of savings banks and cooperative banks contributes to greater stability in the financial system. On the downside, the majority of commercial and state banks were involved in the absurd financing of the asset bubble. In addition, Germany’s specific export predominance makes it heavily dependent on developments in the international economy and on turbulence in the currency system. So the need for a bank and credit bailout plan exists in Germany too, to prevent the failure of banks and a collapse of the credit system.
The Federal Government has been working hard on a rescue plan for the troubled real-estate finance company Hypo Real Estate (HRE). Allowing this company to collapse would have massive repercussions for Germany’s financial community. The bank is one of the largest sources of finance for government funds, regional authorities, the Länder and the commercial property market. Were no solution to be found for the Dax-listed group, this funding would be significantly affected. That would have consequences for the whole economy, while at the same time massively exacerbating the crisis of confidence in the banking community. HRE got into difficulties because of liquidity problems with its state financing subsidiary Depfa. Depfa, which is based in Ireland, had problems refinancing on the capital market following the collapse of the US investment bank Lehman Brothers. The credit crisis dried up the market, leaving Depfa with a huge liquidity gap.
The original bailout plan put together by the German government and the financial industry provided short-term credit of 15 billion euros and long-term refinancing of 35 billion euros into the second half of 2009. This rescue plan, of which the Federal Government was prepared to guarantee 26.5 billion euros with the German federal banks putting up 8 billion euros, fell apart. The reason was that HRE needed “significantly more” funds than had been assumed. Up to 50 billion euros would have been a more realistic estimate. This is because the situation of its subsidiary Depfa has deteriorated massively. The rescue measures for individual banks are – as in the USA and the other leading capitalist countries – merely stop-gaps.
So what is the reason for the ferocity and longevity of the financial crisis? We are facing more than just the consequences of some rather large speculative transactions. It is rather that for a long time now the financial system has been disengaged from the real depreciation of assets. Before the beginning of the crash in the early summer of 2007, the financial superstructure, the artificial construct sitting on top of the real global economy, was overvalued by as much as four times. However, you can’t eat securities. All these products have a hard core: their owners have a claim (in the form of interest) on the results of total economic output. Forms of revenue not based on output had reached a multiple of the disposable annual results of the real economy. It was long overdue: the pyramid of claims collapsed before our eyes. The current corrections on the stock markets amount to a re- dimensioning or obliteration of titles of ownership (= claims on parts of society’s wealth).
As we have said, the key to the crisis lies in a massive real-estate bubble in the United States, where there are loan agreements for around 12 trillion US dollars. Because house prices are now in chronic freefall, more and more people are defaulting on their mortgage loans, i.e. they are no longer able to service them through interest and principal payments.
Neoliberal policies have been encouraging consumers to go into debt for years. Now even true devotees of the capitalist system are observing the decline in middle-class values with bewilderment: “America has turned itself into a fiscally unbridled, irresponsible, short-sighted, debtridden society… Today we basically have a personal savings rate of 0% of available income, in some months even a negative savings rate, whereas 15 years ago this stood at around 8 or 9 per cent.” (Peter G. Petersen, Chairman of the Blackstone Group, writing in the Frankfurter Allgemeine Zeitung on September 18, 2008). The (over-) indebtedness of private households and the public sector is now experiencing a longoverdue and painful correction.
Yes, the middle classes in the USA have been living beyond their means. This can be seen from the mountain of debt accumulated by private households, a mountain that can no longer be sustained under growing pressure from conflicting attempts at (re-)distribution. The same can be seen in the public debt (over 10 trillion US dollars) and the USA’s extreme dependence on the influx of capital in order to meet its many consumer demands. With the recognition that a re-proportioning of production, revenue distribution and consumption is now due, comes the hope that greed will disappear from economic life. However, the gross imbalance in the ratio between earnings and capital cannot be ascribed to the greed of the capital and wealth holders and their helpers. We are dealing with a rupture between the logic of “put your money to work” and the actual process of generating value. However, we should not point the finger only at the USA, although it is certainly the epicentre of the tornado raging in the financial markets. In Ireland, the United Kingdom and Spain and other neighbouring European countries, property prices are also in decline. And on the periphery of the capitalist world system, other consequences can be seen: the annihilation of credit instruments and securities is the prelude to a shrinkage in the real economy.
What are the government bailout plans worth and what are the alternatives?
Financial experts mostly agree that the key challenge is to restore confidence. Only through state intervention, such as the 700 billion dollar bank rescue package now passed in the USA or the state guarantees afforded to banks in the UK, can confidence be restored.
Equally, these rescue packages only make sense if they also have a strong social component, i.e. they include affected homeowners and small savers and pensioners. On the other hand, much greater emphasis must be placed on the effects of the financial crisis on the economy. Because in many countries the crisis is already starting to have an impact on the real economy. The global financial crisis is being followed by a shrinking of the real economy, which will last all the longer if countermeasures are not taken.
Finally, we can say that the players in the financial markets have short memories. If the statutory regulators do not work together more closely worldwide and ensure better identification of transnational systemic risks, there is a danger that the expensive US bailout package and the measures taken by other states will be nothing more than “fast food”.
Support measures – rescue plans for banks, more loans from the central banks, etc. – can prevent a major collapse, but no more than that. Not only are the banks urging that they be allowed to unload their depreciated stocks at “fair prices” on the central banks or on rescue com panies. They also want the central banks to guarantee the liquidity of the credit system. The financial institutions that have been hit are only partly asking for direct state investment. Last but not least, the banks would welcome it if the “market to market” rule were set aside or at least handled with more flexibility. This financial reporting rule currently forces them to value their own assets on quarterly balance-sheets at a level for which there is no pricing on the market or whose structures are massively distorted as the result of fire sales. All these efforts abstract from the fact that we have to reduce the debt pyramid of fictitious capital securities.
In Europe, too many banks are experiencing problems caused by the bubbles which are now bursting on the property markets in Spain, the UK and Ireland. The dip in house prices will prove more serious for some than in the United States. In Greece, Italy and Portugal too there will be trouble with loans on overvalued properties. Furthermore, a large number of European financial institutions have bought these toxic securities from the USA and have yet to acknowledge their loss in value. Many have debts that are much higher relative to their equity than even American banks. On top of that there are the credit losses, which are now being accompanied by recession. But precisely because of the wide variations in the starting conditions on national property markets, the differences in banking and mortgage systems, and the different extent to which national systems of social security are involved in capital markets, there can be no one-size-fits-all European solution, though there may well be agreement on the outline principles of a rescue plan (a kind of European New Deal).
The European Central Bank must cut interest rates. At the same time, governments should set about auditing the banks and deciding which they can allow to go bankrupt and which they have to save. We need a system in which all finance companies above a certain size are subject to the same rules on how much equity they must hold in relation to their debts, as well as reporting regulations. And these rules must be binding and not permit any new exceptions. The self-regulation that governments have relied on up until now simply led to there being no functioning regulatory mechanism at all by the end.
The purchase of “toxic”, unsellable loan packages is only the first step. This must be followed by a programme of wholesale reduction in the volume of mortgage debt of private households. Very many households are practically insolvent, and can no longer afford the high repayments. If a country or a company is insolvent, their debts are written off so that they can continue to operate and start growing again. That is exactly the situation now for private households in some of the large developed capitalist countries: they are over-indebted and must be helped. In a third step, the banks must finally receive new capital, whether from private sources or from the state, if they are ever to start operating again nor mally. All three steps together could provide a solution to the credit crunch.
It is essential that homeowners are helped to reduce their debts and allowed to refinance the remainder at a low rate of interest. A very similar programme was used successfully by the US government to deal with the consequences of the Great Depression during the 1930s. At present, the art of government regulation consists of:
1. Assisting in the long overdue process of a correction in title values in a socially responsible manner. Not all securities can be maintained at their nominal values, but on the other hand old-age pensions, socialsecurity benefits and savings deposits must be protected;
2. Shrinking the capital superstructure while avoiding a collapse of the credit, monetary and currency system;
3. Finally, it must counteract a severe recession without entrenching all existing ownership and distribution structures.
Governments have completely taken their eyes off the massive downturn in the economy. Consumer spending has been falling for four months, and this makes up 70 % of total economic output in the USA. Even official data is predicting negative growth in the third quarter. And the same goes for all highly developed countries, be it in the eurozone or in the UK. We should prepare ourselves for a long, hard recession. Of course, some people made a lot of money during the boom, but at the final reckoning the crisis makes everyone a loser. Billions have been wiped out, and many people are also going to lose their jobs and income.
The real challenge therefore lies in the fact that the serious credit crisis is the prelude to a hard recession. What is likely to be many years of decline could be rendered less severe. The European Central Bank must cut interest rates further. We need a system in which all finance companies above a certain size are subject to the same rules on how much equity they must hold in relation to their debts, as well as reporting regulations. Some countries need a moratorium on mortgage loans. Finally, we urgently need to launch a comprehensive programme of public investment. All this must be accompanied by a reorganisation of distribution ratios, i.e. we must return to rigorous taxation of business and capital income.
Left-leaning or socialist alternatives must be based on national circumstances. For example, even politicians of the right acknowledge that the “Berlin Republic” has also allowed itself to be led up a socio-political blind alley by the EU Commission. The European Commission wanted the system of savings banks and cooperative banks also to be subject to the freedom of the capital market. This destruction was averted. We could encourage this further and – with some accompanying measures – not only give many people the protection they want for their savings, but at the same time lay the basis for a new focus within the credit system on the needs of small and medium-sized enterprises and regional economic and revenue cycles.
The publisher of the Frankfurter Allgemeine Zeitung Frank Schirrmacher asks2: “Who will we have become when this is all over?” His answer: “For the acute threat currently facing our social order, ‘greed’ is the least harmful of all explanations… societies became civilised precisely in order to prevent what now seems possible: destruction through the reckless behaviour of individuals… But because millions of Germans over the past decade have been urged to reorganise their lives along neoliberal lines, to trust the financial markets and mistrust the state, this is now the position of every individual. They must now realise that the rationale of their most important life decisions was based on a purely speculative system.”
The global financial crisis not only affects the financial markets and it is not solely about overcoming the looming world recession. More than this has broken down: Neoliberal ideology promised a reasonable and happy correlation between the individual and globalisation, which with the bursting of the asset bubble is now at an end, including on the economic level. It can no longer be denied that unbridled capitalism has discredited itself through its own logic. The virtues of the genuine businessman were writ small, while greed, arrogance and an absence of social and national loyalty were extolled. The obvious failure of the secular project of unbridled capitalism has not yet worked itself out.
The predominance of the financial markets was micro-economically converted into a hegemony of “shareholder value”, which accelerated the reshaping of the business landscape and led to an expansion of financial transactions. Corporate governance in business is changing. It is all about streamlining the value-added chain, drastically reducing crosssubsidies between business segments, shortening the time-to-market process for new products and optimising innovations by buying up smaller companies. As a result of this concentration on core business, a reorganisation of business networks takes place. The hegemony of “shareholder value” leads to an accelerated reshaping of the business landscape in corporate enterprises, an expansion of financial transactions and a marked increase in enterprise value, which is also reflected in price increases in shares and investment securities. This system is not just broken in terms of its financial superstructure; its very foundations have been shattered.
Suddenly, fans of market control are becoming devotees of regulation. But this is about far more than banking supervision and a few limits on credit loans. The dominance of the financial markets over the real economy must be removed. We need progressive taxation of all capital and asset revenues and the control of financial transactions must also be accompanied by suitable taxation. Furthermore, the privatisation of social security must be reversed and all types of revenue must be brought in to finance public projects.
It is inevitable that Uncle Sam will rescue Wall Street, but we should already be thinking about more far-reaching questions: Who will rescue the rescuer? Government funds, which the USA wanted to use to stabilise its banking system, have already reached the astronomical sum of around 1.7 trillion US dollars, which must be financed on top of the existing deficit. There is a great danger that the US Federal Reserve will have to start printing money, which will lead to inflationary pressure. Whatever happens, the dollar is bound to be extremely volatile in the short term and in the longer term we must be prepared for more bad news and a much weaker greenback. Some financial experts believe that in the medium term this will lead to the creation of a strong bipolar international currency regime, in which more reserves and investments are traded in euros. But most financiers agree that there is no alternative to the dollar, at least in the medium term.
We are living through the beginning of the end of the American Empire, which in the decade following the collapse of the Soviet Union was the dominant power economically, financially, politically and militarily. Great powers, like the British Empire, have traditionally acted as the creditors to the rest of the world. The end began for Britain when it became a net debtor. The same is happening now with the United States.
The USA is the largest debtor nation in the world and is living with a gigantic deficit in its balance of trade, in other words, it imports more goods and services annually – over 700 billion dollars’ worth – than it can sell abroad. Added to this is a government deficit that will soon amount to 1,000 billion dollars. The importance of the dollar as a reserve and trading currency will greatly decrease over time, as it is increasingly replaced by the euro and other currencies. The cleansing of the banking and credit system is not just about a fundamental renewal of the structures of the real economy, it also means establishing a new economic and political order for the global system.
1 On October 9, the Dow Jones Index reached an alltime high of 14,164 points; by 10 October 2008 it had fallen to 8451.
Joachim Bischoff is an economist, co-editor of the journal "Sozialismus", a reader of the VSA-Verlag and member of the Working Group on Alternative Economic Policy (Memorandum-Gruppe).